UNIT-I OVERVIEW OF FINANCIAL MANAGEMENT

Introduction, Scope of Finance, Financial Manager’s role, Financial Goal, Agency Problems, Introduction to three
important decisions-investment decision, Financing decision, Dividend policy decision, Time-value of money,
Future value, Present value, Concept of discounting and compounding, Risk-return trade-off, Bonds- Features of
bonds, Valuation of bonds, Shares- features of shares, valuation models of shares, P/E ratio.
INTRODUCTION

• Financial Management: It is the managerial activity which is concerned with the planning and
controlling of the firm’s financial resources.

• Additionally, financial management is all about learning the most crucial decisions of the firm
related to finance, understanding the theory of financial management with concepts and analytical
insights
SCOPE OF FINANCE

• Production activities (Recruitment and promotion of production employees)

• Marketing activities (sales promotion activities, advertising)

• Finance activities (buying real or financial assets, raise funds- dividends/interests, raising of funds,
investing, distributing returns):

1. Long- term financial decisions (Investment, Financing, Dividend)

2. Short-term financial decisions (Liquidity)

MANAGER’S ROLE

Financial Manager: A person responsible to carry out finance function

• Fund Raising: Raising funds for day-to day activities

• Funds Allocation: Efficient and effective use of funds

• Profit Planning: Operating decisions for pricing, costs, volume and selection of product lines.
 FINANCIAL GOAL: Profit Maximization vs. Wealth
Maximization
Profit Maximization: Would the price system in a free-market economy serve the interests of the
society?
In the economic theory, the behaviour of a firm is analyze in terms of profit maximization, it implies
that the firm produces maximum output for a given amount of input, the underlying logic of profit
maximization is efficiency.

• The profit is considered as the most appropriate measure of a firm’s performance.

Objections to Profit Maximization:

a. Assumes perfect competition

b. Originates from the time of single ownership, now limited liability firms characterized by the
divorce between management and ownership.
c. Vague, ignores timing of returns, ignores risk.
 FINANCIAL GOAL: Profit Maximization vs. Wealth
Maximization
Wealth Maximization: Maximizing NPV (difference between PV of benefits and PV of costs)

+ve NPV adds value for Share holder

-ve NPV reduces value for Share holder

 Fundamental objective of the firm is to maximize the MV of its share.

FINANCIAL GOAL: Profit Maximization vs. Wealth
Maximization
 AGENCY PROBLEMS: Managers vs. Shareholders

Owners/Fund providers/Principal: Shareholders; monitor companies to restrict managers’ role

Managers: Day-to-day decision making; agents; managers should act in the best interest of
shareholders, but they may maximize their own wealth rather shareholder’s wealth

Conflict between interest of shareholders and managers is referred to as Agency cost

State the name of renowned investor in India ?

Rakesh Jhunjhunwala
 TIME-VALUE OF MONEY (TVM)

1. The value of the money does not remain the same and it will changes according to the time. We can
bring the cash flows to a common point of time in order to use any mathematical application.

2. Two tools of TVM( Compounding i.e FV and Discounting i,.e PV)

3. Reasons for TVM:

• Risk
• Preference for consumption
• Investment opportunities

4. Even for the firms, preference for money is

important because of the investment opportunities.
 TIME-VALUE OF MONEY (TVM): Important Terms

1. Required Rate of Return : Risk free rate (compensates for time) + Risk premium (compensates
for risk)

2. Compounding: Calculating FV of cash flows(When the interest earned in the first compounding
period that will be part of principal of second year compounding interest while computing the
interest)
Ex; 1000+ 1000*10% = 1100
1100+1100 *10 % = 1210
1210+ 1210* 10%= 1331

3 Three broad types of FV cash flows ( Lump sum, Annuity, Uneven)

 FUTURE VALUE (FV)

1. How should an investor arrive at comparative values of cash flows that are separated by two or
three or four years later?

2. Compound interest: Interest received on the original amount (principal) as well as on any interest
earned but not withdrawn during earlier periods. Compounding is the process of finding the FVs
of cash flows.
3. Simple interest is calculated on the original amount (principal).

4. Future Value= PV(1+r)n

Example 1: Suppose that you invest Rs. 1000 in a fixed deposit at PNB at 5% interest rate. How much
shall it grow at the end of three years?
2 Suppose that you invest Rs. 10,000 in a fixed deposit at Axis Bank at 6% interest rate.
How much shall it grow at the end of 3 years?
1. Compute the FV factor using scientific calculator
10 % I year
II year
III year

12 % I year
II year
III year

15% 9th year

11th year
12th Year and 13th Year.
 FUTURE VALUE (FV): Annuity

• Annuity is the fixed payment (or receipt) each year for a specified number of years.
• Eg: Equated Monthly Instalments (EMIs)

• Fn= A [(1+r)n-1/r]

Example 2: Suppose Rs. 100 is deposited at the end of each year for the next 3 years at 10% interest
rate. Find the future value for such annuities.
 COMPOUNDING

• Finding the FV of Present money

• In compounding, interest earned in the preceding year is reinvested at the prevailing interest rate for
the remaining period.

• Thus the accumulated amount (principal + interest) at the end of the period becomes the principal
for next period.

• Future Value= PV(1+r)n

 PRESENT VALUE (PV)
1. Present Value= FV/(1+r)n

Example 3: Say Rs. 1080 is receivable at the end of one year from now and the expected rate of
interest which a person can earn on his/her investments is 8% p.a. Calculate the PV for his investment.

2. Compute the PV factor using scientific calculator

10 % I year
II year
III year

12 % I year
II year
III year

15% 9th year

11th year
12th Year and 13th Year.
 DISCOUNTING
• Reverse of compounding, i.e., finding the PV of future money

• PV can be explained in terms of:

i. PV of a future sum: PV= FV/(1+r)n

ii. PV of a future series (Annuity): PV= Annuity Amount * Present Value Annuity Factor (PVAF)

Example 4: An investor wants to find a the PV of 50,000 to be received after 15 years. The interest
rate is 9 %.
Ex: A) An investor receive a sum of Rs 50,000 20 years later and find the
PV of today? (PV factor: 0.178)
Given: B) PVAF(9%,15) = 0.2743 for 65,000
C) 25,000 (5% RRR and Time is 6)
D) 70,000 (7% Int rate and Duration is 8)
E) 1,00,000 (5.5% Rate of interest and 7 years)
F) 1,25,000 (6.5% and 6 years)
 Case study of FPO Adani company in Jan 2023
• Adani 20,000 cr rupees issued for FPO (A follow on public offer)

• Proceeds used for (Squaring of debt payments and capital expenditure)

• Capital expenditure like expanding green field projects such as Highway roads

• Debt payments of subsidiary companies

• Why company doesn't go to lending institutions for fund raising such as Banks or NBFC so on

• Is retail investor worth to invest into this issue; as per data of past, during the pandemic the share price
has listed at 143 Rs (April, 2020)

• Present share price is 4100 trading (Dec, 2022)

 APPLICATION OF TVM: VALUATION OF BONDS
Features of the Bond, Types of Bonds, Cash Flow of Bonds
Introduction
• Assets: Real and Financial

• Determinants of value of financial assets: Risk and Return

“A bond is a long-term debt instrument or security”. These are issued by the government and do not
have any risk of default.

“A debenture is a bond issued by the private companies”

* Rate of interest in case of both bond and debenture is fixed and known to the investor.
 FEATURES OF THE BOND
• Face Value/ Par Value: Issue at this price; interest is paid on this value

• Interest rate/ Coupon rate: Fixed; known to investors; tax deductible;

• Maturity Value/ Redemption value: Repaid at this price; may be at par or premium (above par
value) or discount (below par value)

• Market Value: Price at which traded on stock exchange

 TYPES OF BONDS: Treasury Bills
Issued by the govt. (In India Central & State govt)
Advantages: Interest earned is exempt from state and local taxes; little risk of default.

Types:

1. Treasury bills (T-bills) are short-term securities that mature in less than one year. They are sold at a discount
from their face value and thus don’t pay interest prior to maturity.

2. Treasury notes (T-notes) earn a fixed rate of interest every six months and have maturities ranging from 1 to
10 years. The 10-year Treasury note is one of the most quoted when discussing the performance of the U.S.
government bond market and is also used as a benchmark by the mortgage market.

3. Treasury bonds (T-bonds) have maturities ranging from 10 to 30 years. Like T-notes, they also have a coupon
payment every six months.
 TYPES OF BONDS: Municipal Bonds
• Municipal bonds (“munis”) are issued by state and local governments to fund the construction of
schools, highways, housing, sewer systems, and other important public projects
• Exempt from federal income tax ; offer competitive rates but with additional risk because local
governments can go bankrupt.
• There are two basic types of municipal bonds: General obligation bonds are secured by the full faith and
credit of the issuer and supported by the issuer’s taxing power. Revenue bonds are repaid using revenue
generated by the individual project the bond was issued to fund.
 TYPES OF BONDS: Corporate Bonds
• Companies may issue bonds to fund a large capital investment or a business expansion; carry a higher
level of risk than government bonds; higher potential yields.

• The value of corporate bonds depends on financial outlook and reputation of the company issuing the
bond

• Bonds issued by companies with low credit quality are high-yield bonds, also called junk bonds; have
higher volatility, greater credit risk, and the more speculative nature of the issuer.

• Can be convertible or non-convertible bonds, which can either or not be converted into company stock
under certain conditions.

Zero-Coupon Bonds/Accrual Bonds: This type of bond doesn’t make coupon

payments but is issued at a steep discount. The bond is redeemed for its full value upon maturity. Zero-
coupon bonds tend to fluctuate in price more than coupon bonds. They can be issued by the U.S. Treasury,
corporations, and state and local government entities and generally have long maturity dates.
 CASH FLOW OF BONDS
• Less risk; less of return Government Bond

• So, Government bonds have lower discount rate

• So on the basis of the Cash Flow, bonds may be classified into three categories:

(a) Bonds with maturity: specify interest rate and maturity period; PV of bond is the discounted value of
Cash flows;
(b) Pure discount bonds: Do not carry an explicit rate of interest; sold at discount and redeemed at par;
difference between these two values is the return or YTM.
(c) Perpetual bonds/ consols: indefinite life; so no maturity value; value of bond will simply be the
discounted value of the infinite stream of interest flows.
 CASH FLOW OF BONDS: Bonds with maturity
Example 4: Mr. A is considering purchase of 5-year ₹ 1,000 par value bond, bearing a nominal rate of interest
at 7% p.a. The investor’s required rate of return is 8%. What should he be willing to pay now to purchase the
bond if it matures at par? (₹ 960.5)
 CASH FLOW OF BONDS: Yield-To-Maturity (YTM)
YTM is the measure of a bond’s rate of return that considers both the interest income and any capital gain or
loss.

Where:
C – Interest/coupon payment
FV – Face Value of the security
PV – Present value/price of the security
t – How many years it takes the security to reach maturity
 CASH FLOW OF BONDS: Perpetual Bonds
Example 8: A 10% ₹1,000 bond will pay ₹100 annual interest into a perpetuity.
Calculate the value of the bond if the discount rate is 15%.
Also calculate the value of the bond if discount rate is 20%, 25% and 30%

Note: 1.These bonds don’t have redeeme option because no maturity value. Its rarely in appear in
practice.
2. The value of bond will decrease as the interest rate increases and vice versa.

B0= INT/kd

Where INT; Interest rate

Kd; discount rate

 VALUATION OF SHARES: Features of the Shares, Types
of Shares, Valuation of Shares
Introduction
• Shares: Preference and Ordinary
• Shareholders (owner of shares); Share capital (money contributed by shareholders)
Preference shares: have preference over ordinary shareholders in terns of dividend and capital.
Types:
1. May be issued with or without maturity (Redeemable or Irredeemable)
2. Cumulative (unpaid dividend is accumulated and paid in future) or non-cumulative (Dividends do
not accumulate)
 FEATURES OF PREFERENCE (PS) & ORDINARY
SHARES (OS)
• Claims: PS have a claim on the assets of the company and income prior to OS

• Dividend: Rate is fixed for PS; no rate of dividend for OS

• Redemption value: Redeemable PS have a maturity date whereas irredeemable PS don’t have a
maturity date. On the similar line OS also have no maturity date.

• Conversion: Convertible PS can be converted into OS.

 Value of Preference Shares (PS)- Redeemable/ Dividend
Discount Model
Two-stage
Dividend
Discount Model

Dividend Discount
Example
Model
9
Rs
 Value of Preference Shares (PS)- Irredeemable
Formula:
P0= PDIV/kp
Where,
PDIV= Preference dividend per share in period t
Kp= Required rate of return (discount rate)

Example
10

Rs. 81.82
 Valuation of Ordinary Shares
• Difficult because of 2 factors:
a. Estimates and timing of the Cash flows is uncertain
b. Dividends are generally expected to grow

Single-period valuation (when an investor holds share for one year)

Example 11: An investor expects to pay a dividend of Rs. 2 next year, and would sell the share at an expected
price of Rs. 21 at the end of the year. If the investor’s opportunity cost of capital or the required rate of return
(ke) is 15%, how much should he pay for the share today? Now if this share is trading on the stock market at Rs.
38 today.

(Rs. 20)
 Valuation of Ordinary Shares (Contd…)
Multi-period valuation (when an investor holds share for more than one year)

Example 12:
Dividend (Y2)= Rs 2.10
Price (Y2)= Rs 22.05
Dividend (Y1)= Rs 2
Ke= 15%
Find the price of the share today (P0).
 Valuation of Ordinary Shares (Contd…)- Growth
Multi-period valuation (with constant growth of the share)

Example 13:
DIV1= Rs 2
Growth rate (g)= 5%
Ke= 15%
Find the Present value of the share.
(Rs 20)
 Perpetual Growth Model

Example 14:

Rs. 100
 Perpetual Growth Model

Example 15:

Rs. 91.89
Example
16
Example
17

Example
18
 Price-Earnings (P/E) Ratio
• Price of a share divided by earnings per share (EPS)

• Example 19: Suppose a company has a P/E multiplier of 14.5 and the company expects its EPS to be Rs.
11.67 next year. Calculate the expected share value.

• Is it significant?

• Can P/E ratio mislead?

Thank You